Download OCR Economics: Macroeconomics 2

TOPIC 1
Economic policy objectives and indicators of
macroeconomic performance
WORKBOOK ANSWERS
OCR A-level Economics
Macroeconomics 2
This Answers document provides suggestions for some of the possible answers that might be
given for the questions asked in the workbook. They are not exhaustive and other answers
may be acceptable, but they are intended as a guide to give teachers and students feedback.
The student responses for the longer essay-style questions (green text) are intended to give
some idea about how the exam questions might be answered. The examiner comments (blue
text) have been added to give you some sense of what is rewarded in the exam and which
areas can be developed. Again, these are not the only ways to answer such questions, but
they can be treated as one way of approaching questions of these types.
Topic 1 Economic policy objectives
and indicators of macroeconomic
performance
Economic growth and development
1 The structure of an economy can be explained in terms of the three different sectors of
primary, secondary and tertiary production.
The primary sector refers to that part of the economy which extracts raw materials from
nature. This sector can include industries such as agriculture, forestry, fishing, mining and
quarrying.
The secondary sector refers to that part of the economy which uses the output of the
primary sector to manufacture a variety of different goods. This can include the
manufacture or production of cars, clothes and computers. This sector also includes
construction, such as the building of a motorway, a tunnel or an airport runway.
The tertiary sector refers to that part of the economy which includes services, such as
banking, insurance, tourism, education and distribution.
2 The human development index focuses on the measurement of three aspects of
development: life expectancy, average income in the form of gross national income per
capita, measured through purchasing power parity expressed in US dollars, and years of
schooling. The multidimensional poverty index replaced the human poverty index in 2010
and focuses on three dimensions, health, education and living standards, and on ten
indicators: child mortality, nutrition, years of schooling, child school attendance, electricity,
sanitation, drinking water, type of floor, type of cooking fuel and ownership of assets.
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
1
TOPIC 1
Economic policy objectives and indicators of
macroeconomic performance
3 Economic development differs from economic growth, and economic growth is just one
aspect of the process of economic development. Whereas economic growth specifically
refers to an increase in output in an economy and is usually measured through changes in
gross domestic product (GDP) and, in particular, through changes in real GDP, i.e. after
taking the effects of inflation into account (which is not the case with nominal GDP),
economic development is concerned with bringing about an improvement in the economic
and social well-being of a people. Although growth and development are not the same,
growth will lead to the greater possibility of development taking place, particularly in a
material sense.
4 Economic development is the sustained promotion of the standard of living in a particular
area. It can also be referred to as the quantitative and qualitative changes in a particular
society and economy.
Development is a broad concept and so is often regarded as being multidimensional.
Development goes beyond material progress and, according to Michael Todaro, extends
to include such concepts as sustenance, self-esteem and freedom. Development also
usually includes the idea of sustainable development, i.e. taking into account the needs of
future generations.
There may be economic growth in a country, but at the same time poverty could be
increasing and there could be increasing inequality in the distribution of income and
wealth. Development includes these wider aspects. This is why economic growth might be
seen as a necessary condition for economic development, but it is not a sufficient
condition.
5 The idea of sustainability stresses the fact that in meeting the needs of the present
generation, the needs of the future generation should not be compromised. Sustainable
development refers to the process of meeting human development goals while maintaining
the ability of the systems to continue to provide the resources on which an economy and
society depends. Sustainable development is based on the idea that finite resources
should be used in a way that provides not only for the needs of the present generation, but
also for the needs of future generations.
Sustainable economic development refers to the fact that many resources are finite and
that, in the process of development, there can be a depletion of these resources. The
term, therefore, refers to the idea that the development process needs to take the
environment fully into account. Sustainable development stresses that there should not be
a reliance on the exploitation of resources that cannot be replaced. For example, in terms
of the use of forests, attention needs to be given to the importance of replanting.
According to the World Bank, meeting the needs of future generations means the
balancing of a variety of social, economic and environmental objectives when making
decisions today. Many of these objectives may conflict with each other in the short term,
but in the long term the responsible use of resources now will help to ensure that there are
resources available in the future.
6 Economic growth and development can be promoted through aid in the form of different
kinds of grants and loans, but sometimes this aid can be ‘tied’, i.e. there are conditions
attached to the aid which restrict the freedom of the receiving country to spend that money
as it wishes. Economic growth and development can also be promoted through trade,
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
2
TOPIC 1
Economic policy objectives and indicators of
macroeconomic performance
especially where free trade is encouraged, but sometimes developing economies
specialise in primary products and the price of these has declined relative to the price of
secondary products. There is also likely to be greater volatility in the supply conditions of
primary products, meaning that prices of such products are more unstable.
7 Economic growth and development can be promoted through aid and trade.
Overseas or official development assistance (ODA) is a term used by the Development
Assistance Committee (DAC) of the Organisation for Economic Co-operation and
Development (OECD) to measure aid given to various countries to promote economic
development. Aid can come in several forms, including grants and loans. Sometimes the
aid is bilateral, involving just two countries, and sometimes it is multilateral, involving a
number of countries and/or aid agencies. The aid can be used to finance investment
projects, such as the building of a dam to improve the irrigation system of a region.
Economic development can also be promoted through trade. If a country is able to export
its products to more countries, this should encourage economic and social development,
such as through the employment of a greater number of workers. Some countries have
aimed for an export-led strategy to assist economic growth and development. If free trade
is encouraged, such as through the reduction or abolition of tariffs, it will be easier to
export a country’s products to foreign markets, and this will promote development,
although the extent of this will depend on how much can be exported and the price that is
paid for these exports.
8 There are a number of possible indicators that can be used to measure economic growth
and economic development.
Gross domestic product is one of the usual ways to measure economic growth, especially
when it is measured in real terms to take into account the effects of inflation. When divided
by the population of a country to give a per head or per capita figure, it is a useful way to
measure living standards.
The human development index (HDI) is an attempt, first established in 1990, to look at
economic development from more criteria, going beyond real GDP per capita. The HDI
examines the progress of countries in terms of three criteria: the standard of living, life
expectancy and education. Although it is an improvement on real GDP per capita, it is still
limited to just three criteria.
The multidimensional poverty index (MPI) goes further than HDI and takes into account
ten criteria: child mortality, nutrition, years of schooling, child school attendance, supply of
electricity, sanitation, quality of drinking water, type of kitchen floor, type of cooking fuel
and ownership of assets. This indicator has the advantage of including many more criteria
than HDI, such as the quality of drinking water.
The genuine progress indicator (GPI) supplements GDP by taking into account a number
of environmental and social factors that are not measured by GDP. Examples of such
factors include resource depletion, pollution and long-term environmental damage.
Some indicators also attempt to explore the relationship between economic growth and
happiness. The Easterlin paradox, named after the economist Richard Easterlin, points out
that in many countries, the average level of happiness did not vary greatly with national
income per person. For example, although income per person rose steadily in the USA
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
3
TOPIC 1
Economic policy objectives and indicators of
macroeconomic performance
between1946 and 1970, average happiness showed no long-term trend and it even
declined between 1960 and 1970.
The Office for National Statistics (ONS) has produced data under the heading Measuring
National Well-being. Its aim is to develop new measures of national well-being to provide a
fuller picture of how society is doing by supplementing existing economic, social and
environmental measures.
9 The main purpose of the International Monetary Fund is to coordinate the international
monetary system. Its objective is to ensure the stability of the world monetary system and
to provide financial support, if required.
10 The International Monetary Fund, set up in 1944, has as its aim the supervision and
coordination of the international monetary system. It aims to ensure that there is stability in
the international system and it can pursue this aim by providing financial support to
countries which are experiencing economic difficulties. This financial support can be useful
in the promotion of economic growth and development. This support is sometimes linked
with a requirement that a country carries out certain policies.
11 The main purpose of the World Bank is to provide finance to those countries that need it,
especially developing economies. Loans are sometimes conditional on a country’s
government adopting certain economic policies.
12 The World Bank, or the International Bank for Reconstruction and Development, as it is
officially known, was also set up in 1944. It can provide financial support to countries that
are facing economic difficulties, and this support can help countries to achieve economic
growth and development. However, like the IMF, it can attach conditions to this financial
support.
13 The main purpose of the World Trade Organization is to monitor and regulate international
trade. Its objective is to reduce trade barriers as much as possible so as to encourage free
trade, and free trade is likely to help in the promotion of economic growth and
development.
14 The World Trade Organization, set up in 1995, aims to promote free trade between as
many countries in the world as possible. It is opposed to trade barriers and aims to reduce
as many of these as possible. It encourages discussions among member countries and
these discussions are usually given a name. The most recent discussions have been
known as the Doha Round. The promotion of free trade is also likely to promote economic
growth and development.
Unemployment/employment
15 NAIRU refers to the non-accelerating inflation rate of unemployment.
16 The non-accelerating inflation rate of unemployment (NAIRU) can also be referred to as
the natural rate of unemployment. It means the level of unemployment at which the rate of
inflation is constant. It is the level of unemployment in an economy that cannot be reduced
in the long term by increasing aggregate demand. It is often associated with Monetarist,
rather than Keynesian, economists, such as Milton Friedman.
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
4
TOPIC 1
Economic policy objectives and indicators of
macroeconomic performance
Once unemployment falls below a certain level, the rate of inflation is likely to accelerate.
On the other hand, once unemployment rises above a certain level, the rate of inflation is
likely to fall. It is even possible that the rate of inflation becomes negative and there is
deflation, i.e. the general level of prices in an economy falls. There is thus a trade-off
between the level of inflation and the level of unemployment in an economy. The natural
rate of unemployment therefore occurs when an economy is at full employment, i.e. when
the labour market is in equilibrium.
17 Patterns of employment and unemployment can have a number of consequences for an
economy. These can include technological unemployment and cyclical unemployment. A
number of people have lost their jobs as a result of technological progress over the last
half century, which has required money to be spent on retraining and re-skilling schemes.
The financial crisis of 2007–08 led to a credit crunch and a severe recession in 2008–09,
which led to the Monetary Policy Committee reducing the bank rate to 0.5% in March 2009
in an attempt to stimulate the level of aggregate demand in the economy.
In terms of employment, there has been a steady increase in the UK and there are more
workers employed than ever before. However, many of these are part-time workers and
indeed a number of these are on zero hours contracts, which means that they are not
guaranteed employment, but are simply asked to work when the need arises.
Inflation
18 A real value is one which shows a change over a period of time with the effects of inflation
removed. This means that the value will be expressed in constant prices.
19 Both indices can be used to measure the rate of inflation in an economy, but there are
differences between them. The consumer prices index (CPI) is the standard measure for
international comparisons, but does not include housing costs. The retail prices index
(RPI) does include housing costs, such as council tax and mortgage interest repayments.
The RPI usually shows a higher rate of inflation than the CPI.
Income distribution and welfare
20 A Lorenz curve can be used to explain how income and wealth are distributed in an
economy. It is a visual representation showing inequality in the distribution of income and
wealth in an economy. An example of one is shown in the diagram.
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
5
TOPIC 1
Economic policy objectives and indicators of
macroeconomic performance
Figure 1
The 45-degree line shows the line of equality which would exist if a certain percentage of
the population received the same percentage of income. The Lorenz curve shows the
extent to which the equality of income deviates from this 45-degree line of equality. The
more unequal the distribution of income, the more the Lorenz curve will deviate from the
45-degree line. Conversely, the more equal the distribution of income, the closer the
Lorenz curve will be to the 45-degree line.
The Lorenz curve is therefore a useful way of showing the distribution of income and
wealth in an economy.
21 The Gini coefficient refers to the ratio of the area between the 45-degree line of equality
(where income is evenly distributed) and the Lorenz curve, and the total area under the
line of equality.
22 A Gini coefficient of 0 would show the situation where there was absolute equality in the
distribution of income and wealth in an economy. A Gini coefficient of 1 would show the
situation where there was absolute inequality in this distribution. In the table, it is clear that
the distribution of income and wealth is more equal in Sweden because this country has
the lowest Gini coefficient of 0.259. It can also be seen that the distribution of income and
wealth is less equal in Mexico because this country has the highest Gini coefficient of
0.476. The UK is in the middle with a Gini coefficient of 0.345.
23 It is possible to distinguish between two different types of poverty — absolute and relative
poverty.
Absolute poverty is where people are unable to afford the basic necessities of life. For
example, this is where certain people are malnourished and homeless. In an attempt to
put a figure on absolute poverty, the World Bank stated in 1990 that absolute poverty
existed in a country when people were trying to survive on less than US$1.00 a day. This
figure was increased to US$1.25 in 2005.
Whereas absolute poverty is measured by the same monetary figure in all countries,
relative poverty is where some people have less income than others in a society. Relative
poverty is defined in terms of the context of a particular society and occurs when people
are unable to buy what others are able to afford. This does not necessarily mean that they
are poor in absolute terms.
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
6
TOPIC 1
Economic policy objectives and indicators of
macroeconomic performance
Trends in macroeconomic indicators
24 Economic growth in the UK has been averaging about 2.2%, but since the credit crunch of
2007–08 there have been two recessions and very nearly a third. In 2015, growth was
between 2.4% and 2.6% p.a.
The inflation rate has generally been over the target figure of 2% in recent years, reaching
as high as 5.1%. In 2015, however, inflation (as measured by the consumer prices index)
was below the target figure at 0.1% and in some months actually went into negative
figures, indicating a situation of deflation.
The unemployment rate has generally been higher than in the recent past since the credit
crunch of 2007–08, although there has been an increase in the labour force to over 29
million. In 2015, the unemployment rate was 5.4% as measured by the Labour Force
Survey.
Finally, the balance of payments on current account has been in deficit, although the
invisible balance has generally been in surplus. In 2015, the current account balance for
the year was in deficit by about US$150 billion.
Exam-style questions
25 Student answer:
Economic growth and economic development are likely to involve a process of
reallocation of resources so that there is a movement away from the primary sector
and a movement towards the secondary and tertiary sectors. In this way, economic
development can be seen as when a country moves away from being a developing
country and towards being a developed country.
The candidate has clearly demonstrated that they understand the relationship between
economic growth and development and the likely changes in the structure of an economy.
Economic growth and economic development are related and growth will lead to
the greater possibility of development taking place, particularly in a material sense.
However, they are not the same and economic growth is just one aspect of the
process of economic development. Whereas economic growth specifically refers to
an increase in output in an economy, economic development is concerned with
bringing about an improvement in the economic and social well-being of a people.
There may be economic growth in a country, but at the same time poverty could be
increasing and there could be increasing inequality in the distribution of income
and wealth. Development includes these wider aspects. This is why economic
growth might be seen as a necessary condition for economic development, but it is
not a sufficient condition. Development is a broader concept and so is often
regarded as being multidimensional. Development goes beyond material progress
and, according to Michael Todaro, extends to include such concepts as sustenance,
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
7
TOPIC 1
Economic policy objectives and indicators of
macroeconomic performance
self-esteem and freedom. Development also usually includes the idea of
sustainable development, i.e. taking into account the needs of future generations.
The candidate has made clear the relationship between, and the difference between, economic
growth and development.
Sustainable development is based on the idea that finite resources should be used
in a way that provides not only for the needs of the present generation, but also for
the needs of future generations. Sustainable economic development refers to the
fact that many resources are finite and that, in the process of development, there
can be a depletion of these resources. The term, therefore, refers to the idea that the
development process needs to take the environment fully into account.
According to the World Bank, meeting the needs of future generations means the
balancing of a variety of social, economic and environmental objectives when
making decisions today. Many of these objectives may conflict with each other in
the short term, but in the long term the responsible use of resources now will help
to ensure that there are resources available in the future.
The candidate has demonstrated a sound understanding of the link between sustainable
development, economic development and economic growth.
There is thus a close relationship between economic growth, changes in the
structure of an economy, economic development and sustainable development.
The conclusion is rather limited and could have been developed more fully. MARK: 18/25
26 Student answer:
The traditional approach to measuring development has been through GDP per
capita, i.e. take the GDP of a country and divide it by the population of the country
to give a per head or per capita figure. An even better approach has been to take
into account the effects of inflation by using real GDP per capita.
A useful start by bringing in both GDP per capita and real GDP per capita.
However, given that development is a wider concept than growth, other approaches
to measuring development have been introduced. One of these is the human
development index. This is a wider concept than GDP per capita. It has included
GDP per capita within it, although since 2010 GDP per capita has been replaced by
gross national income (GNI) per capita in $US at purchasing power parity.
The contrast between growth and development could have been developed more fully. It is good,
however, to demonstrate knowledge of recent changes in the construction of the HDI.
In addition to GNI per capita, the HDI also includes two other elements. One is life
expectancy at birth. The other is years of education; this is actually made up of two
elements, mean years of schooling and expected years of schooling.
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
8
TOPIC 1
Economic policy objectives and indicators of
macroeconomic performance
There could have been a more detailed consideration of these two aspects.
The HDI is, therefore, considered to be a better indicator of development than GDP
per capita because it also includes life expectancy and years of schooling.
The conclusion could have been developed more fully, discussing in greater depth the
advantage of HDI over GDP. MARK: 7/12
27 (a) Student answer:
The increase in the person’s real income is 5.2% − 2.9% = 2.3%.
The answer is correct and gains both marks.
(b) Student answer:
Economists are interested in changes in real income because a real value takes into
account the impact of inflation. If a person’s income rises by less than the rate of
inflation in an economy, then the person’s purchasing power will actually fall, i.e.
they will be worse off because the rise in income has not been enough to offset the
rise in the general level of prices in the economy.
Changes in nominal income simply show a change in a person’s income, without
taking into effect the impact of the rate of inflation.
The candidate understands the difference between nominal and real income and is able to
explain why economists are particularly interested in changes in real income. MARK: 3/4
28 C
29 C
30 D
31 A
32 B
33 B
34 B
35 A
36 C
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
9
TOPIC 2
Aggregate demand and aggregate supply
Topic 2 Aggregate demand and
aggregate supply
Aggregate demand
1 The term ‘accelerator’ shows the relationship between investment and the rate of change
of output.
2 The theory of the accelerator is a way of explaining the relationship between investment
and the rate of change of output. The most important feature of the accelerator idea is that
it is not the level of output that determines investment but the rate of change of that output.
Investment can therefore be said to be a function of a change in national income.
If the level of output grows faster than was previously the case, the rate at which new
productive capacity is created will need to increase. However, if the level of output
stabilises, it will not be necessary to have any additional investment, other than what is
needed to take account of depreciation. In this situation, investment will actually fall.
The accelerator theory therefore explains why investment changes more than output. It
relates to the induced effect on investment of a change in national income, in contrast to
the multiplier which explains the effect of an autonomous change in investment on national
income, and it assumes a fixed capital–output ratio.
Aggregate supply
3 It is possible to distinguish between two different approaches to aggregate supply.
Figure 2
The Keynesian approach emphasises that the AS curve is a horizontal, perfectly elastic,
line up to the full employment level of real output. An increase in aggregate demand, such
as from AD to AD1, will increase the level of real output but not the level of prices. When
the full employment level of real output is reached, however, the level of prices will
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
10
TOPIC 2
Aggregate demand and aggregate supply
increase so that the AS curve now becomes a vertical, perfectly inelastic, line. This is
shown in Figure 2.
Figure 3
The neo-classical approach to aggregate supply adopts a different approach from the
Keynesian one. This is shown in Figure 3. In this situation, the AS curve is a vertical line.
Any increase in aggregate demand, such as from AD to AD1, will increase the price level,
but not output and employment. In order to increase output and employment, supply-side
policies are needed to shift the AS curve to the right. These could include measures to cut
taxes so as to increase the incentive to work, reduce the power of trade unions, cut
benefits to make working appear more attractive, deregulation to increase the level of
competition in certain industries and the creation of a more entrepreneurial business
climate.
Macroeconomic equilibrium
4 There are important differences between these three schools of thought on how the
macroeconomy operates.
The Keynesian approach emphasises that governments will need to play a key role in
helping an economy to achieve full employment. If aggregate demand is too low, a high
level of unemployment will arise which is unlikely to be solved by market forces alone.
This is in contrast to the neo-classical school of thought, which puts the emphasis on
market forces achieving macroeconomic equilibrium without a need for a great deal of
government intervention.
The Austrian school of thought, such as the ideas of Friedrich Hayek, also focuses on the
idea of macroeconomic equilibrium coming about largely as a result of market forces
rather than through government intervention.
The Phillips curve
5 In the short run, the Phillips curve moves upwards, i.e. it shifts to the right, and so the
trade-off between inflation and unemployment remains, but now at a higher rate of inflation
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
11
TOPIC 2
Aggregate demand and aggregate supply
than was previously the case. The Phillips curve may therefore become vertical in the long
run.
6 The Phillips curve shows the relationship between the rate of inflation and the rate of
unemployment in an economy, emphasising the trade-off between them. This means that
increases in the inflation rate would be associated with decreases in the unemployment
rate, while decreases in the inflation rate would be associated with increases in the
unemployment rate. Thus, the Phillips curve is downward sloping, at least in the short run.
This is shown in Figure 4.
Figure 4
However, it is also necessary to consider the expectations-augmented Phillips curve. If
people have strong expectations of inflation, they are likely to want to negotiate large wage
increases to ensure that there is not a loss in the purchasing power of the money they
earn. The effect of this is that at any given level of unemployment, the rate of inflation will
increase.
It therefore becomes necessary to distinguish between the short-run and the long-run
Phillips curve. In the short run, the Phillips curve moves upwards, i.e. it shifts to the right,
and so the trade-off between inflation and unemployment remains, but now at a higher
rate of inflation than was previously the case.
However, in the long run the Phillips curve may become vertical. Workers continue to have
strong expectations of inflation and this is known as the adaptive-expectations
hypotheses, i.e. they base their view of future inflation rates on what has happened in the
past. The short-run trade-off comes about because of ‘money illusion’, i.e. workers focus
on money wages and not real wages. In the long run, there is no trade-off between the
rate of inflation and the rate of unemployment and the economy returns to its long-run
equilibrium. The real wage is restored to long-run equilibrium and the economy is at full
employment. This is shown in Figure 5.
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
12
TOPIC 2
Aggregate demand and aggregate supply
Figure 5
The economic cycle
7 The four stages of the economic cycle are referred to as boom, recession, slump and
recovery.
8 The economic, trade or business cycle refers to the fluctuations in output and employment
in an economy over a period of time. During this time, economies will go through four
stages of the cycle: periods of boom, recession, slump and recovery. The long-run trend,
however, will tend to increase.
A boom is the phase of the economic, trade or business cycle in which economic growth is
at its most rapid. As the recovery in the economy improves, economic growth becomes
faster until it is growing at a rate which is unsustainable in the long run.
A recession is the downswing in the economic, trade or business cycle and it is during this
phase of the cycle when aggregate demand may begin to decline. Business confidence
will be low, so investment is likely to be falling. The technical definition of a recession is
two successive quarters of negative growth. The most severe recent depression in the
world was in 2008–09.
A slump is the low point of the economic cycle. At this phase in the cycle, aggregate
demand is well below the level of full-capacity output in an economy.
A recovery is the upswing phase of the cycle, when aggregate demand and output begin
to rise, although this is likely to be at a slow pace to begin with.
9 It is important to distinguish between short-run causes of economic growth and long-run
causes of economic growth.
Short-run causes of growth can include changes in aggregate demand, short-run changes
in aggregate supply, the interaction of the multiplier and the accelerator and the economic
cycle.
Long-run causes of growth can include changes in long-run aggregate supply, the quantity
and quality of the labour force and changes in capital stock.
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
13
TOPIC 2
Aggregate demand and aggregate supply
Changes in long-run aggregate supply will be relatively elastic to begin with, as output
grows, but eventually, as the availability of resources becomes increasingly limited, longrun aggregate supply becomes increasingly inelastic until it eventually becomes a vertical
line.
However, it is possible in the long run to change the quantity and/or quality of resources.
This would allow the long-run supply curve to shift. For example, over time, the labour
force can increase, especially as a result of net migration into a country. The quality of a
labour force could also be increased as a result of a government’s supply-side measures
in proving training and retraining courses, leading to an enhancement of the skills of
workers, making them more employable.
The capital stock can also be changed in terms of quantity and/or quality in the long run.
For example, replacement capital will be able to take advantage of technical progress and
innovation, making the equipment more effective and cost-efficient.
10 The multiplier refers to the amount by which an increase in injections into the circular flow
of income will be able to increase the level of total income in an economy. These injections
can be in the form of investment, government spending and exports. The size of the
multiplier will depend on the extent to which these injections into the circular flow of
income leak away into withdrawals from the circular flow of income, in the form of savings,
taxation or imports.
The size of the multiplier in an economy can be calculated in the following way:
1
________________
MPS + MPT + MPM
MPS refers to the marginal propensity to save, MPT refers to the marginal propensity to
tax and MPM is the marginal propensity to import.
The accelerator refers to the relationship between investment and the rate of change of
output in an economy. It is important to understand that it is not simply the change in
output that is important, but the rate of change. The effect of this relationship is that
investment is likely to fluctuate more than output.
The size of the accelerator in an economy can be calculated in the following way:
I = f (change in Y)
This means that investment is a function of the rate of change in national income.
The interaction between the multiplier and the accelerator is very important in explaining
the cyclical changes that can occur in an economy. For example, an increase in
investment during the upswing of the economic cycle will have a multiplier effect in an
economy, leading to a larger increase in income. As an economy approaches full capacity,
the accelerator theory stresses that investment will fall, creating a downward or negative
multiplier effect. Eventually there will be a need for investment to grow. There is thus an
economic cycle which is continually repeating itself.
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
14
TOPIC 2
Aggregate demand and aggregate supply
11 An output gap shows the difference between the actual output of an economy and the
potential output of that economy when it is working at full capacity. It is possible to look at
changes in real GDP over a period of time and compare this with the long-run trend rate of
growth to see if there is a deviation or divergence. This output gap can be either positive
or negative.
12 If the output gap is negative, this means that aggregate demand is below what an
economy is able to produce. In this situation, there will be a deflationary gap and there will
be a relatively high rate of unemployment in the economy.
If the output gap is positive, this means that aggregate demand is more than what an
economy is able to produce. In this situation, there will be an inflationary gap.
Exam-style questions
13 (a) Student answer:
The multiplier is calculated by 1 divided by MPS + MPT + MPM. The answer is
therefore 1 divided by 0.1 + 0.3 + 0.4 = 1/0.8 = 1.25.
The candidate has produced the correct answer. MARK: 2/2
(b) Student answer:
The circular flow model stresses that there are three injections into an economy
(government spending, investment and exports) and three leakages or withdrawals
from an economy (taxation, savings and imports). The size of the national income
multiplier is determined by the strength of the marginal propensity to save, the
marginal propensity to tax and the marginal propensity to import. To calculate the
size of the national income multiplier, the formula is 1 divided by MPS + MPT +
MPM.
The candidate clearly has an understanding of the circular flow of income in an economy and is
able to identify the three injections into, and the three leakages or withdrawals from, the circular
flow of income. However, although the three factors are referred to, and the calculation is given,
there is no clear explanation of what is meant by these three factors. MARK: 3/6
14 C
15 B
16 A
17 A
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
15
TOPIC 3
The application of policy instruments
Topic 3 The application of policy
instruments
Fiscal policy
1 Average and marginal rates of tax can be distinguished. The average tax rate is the
average percentage of total income which is paid in taxes. The marginal tax rate is the
percentage of additional income which is paid in taxes. The distinction is an important one
because if a tax system is progressive, it will mean that the marginal rate of tax will be
higher than the average rate of tax.
2 The Laffer curve shows the relationship between the rate of tax and the revenue that is
obtained from the tax. The curve shows that higher tax rates will eventually lead to a fall in
the revenue received from a tax, i.e. the higher rate acts as a disincentive. This can apply
to firms, in relation to corporation tax, and to employees, in relation to income tax.
Although the rate of tax is higher, fewer people are working and so the revenue obtained
from the tax will be lower. In such a situation, a tax cut could lead to an increase in
revenue for a government because more people will want to work and firms will want to
expand.
The Laffer curve shows that at a low level of taxation, the revenue from tax will increase if
the tax rate is raised. On the other hand, at a high rate of taxation, the revenue from tax
will decrease if the tax rate is raised, demonstrating the disincentive effect of a tax
increase.
3 An automatic stabiliser is a fiscal policy which works to reduce fluctuations in income over
the course of the trade cycle without a government needing to further intervene, especially
in relation to the different stages of the trade cycle.
4 Income tax can be regarded as an example of an automatic stabiliser. As incomes rise in
the boom phase of the trade cycle, the revenue gained from income tax rises more than
proportionately because income tax is a progressive tax.
As incomes fall in the recession phase of the trade cycle, the revenue gained from income
tax falls more than proportionately. Also, government spending on unemployment benefits
will automatically rise if the level of unemployment increases and so the extra spending
will have the effect of compensating for the reduction in the earned income of workers.
The effect of income tax and unemployment benefits working as automatic stabilisers in
this way is that income tax takes more spending power out of an economy during a boom
than it does in a recession. This helps to counteract the fluctuations in aggregate demand
and so reduce the impact of these cyclical events.
5 Fiscal policy could lead to a situation of ‘crowding out’ or ‘crowding in’ when it is
expansionary, such as in a time of recession or depression.
If there is an increase in government spending and/or a decrease in tax revenue,
increased borrowing may be necessary to finance this deficit. If a government needs to
borrow more money to finance its increased expenditure, this could reduce investment
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
16
TOPIC 3
The application of policy instruments
spending by the private sector, i.e. the increased borrowing ‘crowds out’ private investing.
Crowding out can therefore be seen as a situation where increased public expenditure
diverts money or resources away from the private sector.
On the other hand, such a situation could give rise to ‘crowding in’. If a government
decides to increase its spending, it can possibly lead to higher private investment. Deficit
spending by a government is likely to stimulate economic activity and, as an economy
grows, private firms may be encouraged to expand and so investment will be encouraged,
not discouraged as the ‘crowding out’ hypothesis would suggest.
Monetary policy
6 The liquidity trap refers to a situation in the liquidity preference theory where an increase in
the money supply, beyond a certain point, does not affect the interest rate. Normally, an
increase in the money supply will lead to a fall in the interest rate, but when the demand
curve for money becomes horizontal, such a shift to the right will have no effect on the
interest rate. The interest rate will fall to a point beyond which it cannot go any lower.
Figure 6
The diagram shows that when there is a shift to the right of the money supply curve, from
MS to MS1, increasing the quantity of money from 0Q to 0Q1, the interest rate remains
constant at 0r.
7 A government may decide to target inflation. This means that a figure will be established,
e.g. 2% in the UK, which a government will aim to achieve over a period of time. There is
usually a certain range of inflation that will apply in relation to the target, e.g. in the UK it is
1% above or below the target figure.
Exam-style questions
8 Student answer:
It is important to understand the relationship between a tax rate and the amount of
revenue obtained by a government from imposing that tax. It might be assumed
that as the rate of a tax increases, the amount of revenue that it produces also
continues to increase, but this need not necessarily be the case.
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
17
TOPIC 3
The application of policy instruments
The candidate has provided a useful introduction in terms of what might be expected to be the
case.
The Laffer curve shows the relationship between the rate of tax and the revenue
that is obtained from the tax. It shows that higher tax rates will eventually lead to a
decline in the revenue received from a tax. This is because the higher rates can act
as a disincentive for firms and employees. A high rate of direct tax, such as income
tax, may have a disincentive effect on employees and a high rate of direct tax, such
as corporation tax, may have a disincentive effect on firms. Although the rate of
tax is higher, fewer people will now be working and so the revenue obtained from
the tax will be lower.
Figure 7
The candidate has brought in the Laffer curve to show that the relationship is not as
straightforward as might be supposed and has included a diagram to illustrate the relationship.
In such a situation, a cut in both income tax and corporation tax could lead to an
increase in revenue for a government because more people will want to work and
firms will want to expand. The Laffer curve is therefore extremely useful in
showing this relationship between the tax rate and tax revenue.
The conclusion is rather limited and could have been developed more fully. MARK: 8/12
9 Student answer:
Many countries set an inflation target and this can be of two types.
Symmetric inflation targeting is where a central bank is required to respond to a
situation where the rate of inflation in an economy is either too high or too low.
This is the case in the UK where the inflation target is 2%. An inflation rate below
the 2% target is regarded as a problem just as much as an inflation rate above the
target. The inflation target is therefore symmetrical.
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
18
TOPIC 3
The application of policy instruments
The candidate has explained what is meant by symmetric inflation targeting and has given data
from the UK to support the point.
If the target is missed by more than 1% on either side, i.e. if the inflation rate is
more than 3% or less than 1%, the governor of the Bank of England is required to
write an open letter to the chancellor of the exchequer explaining the reasons why
the rate of inflation has increased or fallen to such an extent and outlining what the
Bank proposes to do to ensure that the rate of inflation comes back to the target
figure.
The candidate has given a clear explanation of what happens in the UK whenever the inflation
target is missed.
Non-symmetric, or asymmetric, inflation targeting is when a central bank is only
required to take action when the rate of inflation is either too high or too low but
not in both instances. Usually this will be when the rate of inflation is too high. In
such a situation, the central bank is not required to take any action when the rate of
inflation falls below the inflation target.
The candidate has contrasted asymmetric with symmetric inflation targeting, pointing out the
distinction between the two approaches. MARK: 4/4
10 D
11 B
12 C
13 B
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
19
TOPIC 4
The global context
Topic 4 The global context
Globalisation
1 Globalisation refers to a number of different characteristics. First, there is increasingly a
world market, both in terms of goods and services and in terms of capital. Second, there is
more coordination between governments in terms of the macroeconomic policies that are
followed. Third, there has been a growth in world trade, improving the standard of living of
many people. Fourth, there has been increasing scope for multinational companies to
extend their operations all over the world. Fifth, the development of technology has
contributed significantly to the growth of the idea of a world market, especially in terms of
the use of the internet.
2 Globalisation is caused by a number of factors. The development of an increasingly world
market is due to the need of companies to cut costs and to produce more. Multinational
firms have grown greatly in recent years, partly to take advantage of different factor
endowments in various countries, such as the different costs of labour, and partly to
produce more, the larger market leading to larger profits.
It is not only in terms of an increasingly world market that globalisation is taking place — it
is also the result of movements in capital. The financial system has become more
integrated and capital has become increasingly mobile. For example, many companies
now have their shares quoted on a number of stock exchanges around the world.
Advances in transportation and communication have also contributed towards the greater
interdependence of countries in terms of their economic activities.
The International Monetary Fund has identified four essential aspects of globalisation.
These are trade and transactions, capital and investment movements, the migration of
people and the dissemination of knowledge.
3 A multinational firm is one which operates in more than one country. This has to involve
some form of actual economic activity in another country and so, therefore, means more
than just selling in different countries. Car companies, for example, often have factories in
different countries. A multinational firm that builds a factory in another country is involved
in what is termed ‘foreign direct investment’.
International trade
4 This theory helps to explain why countries trade goods and services with each other. One
condition for trade between two countries is that the countries differ in terms of the
availability of factors of production, e.g. one country may have a great deal of capital but
relatively few workers, while another country may have many workers but relatively few
machines.
According to the Heckscher–Ohlin theory, a country will specialise in the production of
goods and services that is it most suited to produce, i.e. a country will export those goods
that are intensive in the use of their more plentiful factor of production, and import those
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
20
TOPIC 4
The global context
goods that are intensive in the use of their scarce factor. The effect of this is that relative
prices, and relative factor prices, in different countries tend to be equated.
Exchange rates
5 An exchange rate refers to the rate at which one currency can be exchanged for another,
i.e. it is the price or value of one currency in terms of other currencies.
6 Exchange rates can be measured in different ways. A bilateral exchange rate involves a
pair of currencies, i.e. it is the rate at which one currency can be exchanged for another.
An effective exchange rate refers to a weighted average of a basket of currencies. The
weightings are in relation to the amount of trade involving the different countries.
A nominal exchange rate refers to the value of a currency compared with other currencies
without taking into account the inflation rates in the different countries, i.e. it does not show
the purchasing power of one currency compared with another. In contrast, a real exchange
rate refers to the value of a currency compared with other currencies after taking into
account the inflation rate in different countries, i.e. it does show the purchasing power of
one currency compared to another.
7 This theory takes into account the different price levels in various countries when their
exchange rates are being compared. It enables exchange rates to be compared after they
have been adjusted to give comparisons of purchasing power in the different countries.
Once this adjustment has been made, the two amounts of money being compared will be
able to buy identical baskets of products in both countries. This is an advantage over
actual or nominal exchange rates.
Trade policies and negotiations
8 There are a number of different methods of protectionism that can be used to reduce the
number of imports coming into a country.
A tariff is a tax or duty that is imposed on an imported good. It will be included in the price
of the product and, as long as demand is elastic, the higher price should discourage
consumption of the product.
A quota is a limitation on the amount of imports that come into a country. It can be in the
form of a limit on the number of products allowed in, the value of the products or the
market share that they represent.
A subsidy is a financial payment that is paid to a producer to lower the costs of production
and, therefore, the price to be charged. If domestic producers are supported by subsidies,
this will make these goods more competitive and this is likely to reduce the demand for
imported goods.
Exchange controls refer to restrictions on the currency that is made available to pay for
trade. Imports could be reduced if it is made more difficult to obtain the money to pay for
them.
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
21
TOPIC 4
The global context
An embargo is an actual ban on the importation of products. This will usually apply to
imports from one country or a specific group of countries.
Administrative procedures and restrictions can be used to make the process of importation
more difficult because of all the ‘red tape’ that is involved.
Voluntary export restraints refer to a situation where a country tries to persuade another
country to voluntarily limit its exports. This can be successful because if it is not agreed,
there can be a threat of bringing in protectionist methods.
9 Some countries decide to protect their domestic producers for a variety of reasons.
One particularly important reason could be to support an infant industry in an economy,
i.e. one that has only recently been established and which is therefore not yet ready to
compete in international trade with more established firms from other countries. These
industries can also be referred to as sunrise industries.
Another argument might be to protect declining industries, i.e. those industries which are
in the process of decline, but which a government might want to support for at least a
limited period of time to enable workers to find new jobs in other industries. If this was not
the case, there could be a very dramatic increase in the rate of unemployment in the
country. These industries can also be known as sunset industries.
One argument that is regarded as relatively strong is that of opposition to dumping.
Dumping refers to the fact that imported goods are not only being sold cheaply, but are
being sold at a price that is below the cost of production in the home country.
A government could decide to impose a tariff as a means of raising revenue, especially on
those imported goods for which the price elasticity of demand is relatively inelastic.
Even though the advantages of free trade are well known, it is therefore the case that
some countries may prefer to use protectionist methods to protect at least some of their
domestic producers for a period of time.
10 The World Trade Organization was set up in 1995 and now has 163 members.
Its main purpose is to encourage free trade through its supervision of international trade. It
deals with the regulation of trade between the member countries and provides a
framework for negotiating trade agreements. There are a number of WTO agreements
which the member countries are required to adhere to. It also can be involved in the
resolution of trade disputes between member countries.
The Doha Round of negotiations has not been as successful as had been hoped. One of
the difficulties has been over the provision of subsidies to farmers in a number of
countries.
11 A free-trade area refers to a form of integration where a group of countries promote free
trade among themselves, but keep a separate set of trade barriers against other countries.
A customs union, like a free-trade area, encourages free trade among the member
countries but, unlike a free-trade area, it imposes a common external tariff against
products from countries outside the union.
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
22
TOPIC 4
The global context
A single market refers to a form of integration where there is an attempt to establish a
unified market, providing for the free movement of goods, services and people.
An economic union refers to a form of integration where the member countries agree to
use the same economic policies and regulations.
A monetary union is a form of integration where countries agree to use a common
currency. The countries in the European Union which are part of the Eurozone would be
an example of this form of integration.
12 Membership of the European Union has a number of advantages and disadvantages to
member countries.
The main advantage of membership of the EU is that the 28 countries constitute a
relatively large market of over 500 million people. It is therefore possible for firms to benefit
from this market, giving rise to potential advantages of economies of scale in terms of
lower costs of production. The labour market has been made more flexible because
people have the right to work in any of these countries. A number of jobs have been
created as a result of the existence of the EU. Funds have been provided to those areas in
the 28 countries that are economically disadvantaged. Many EU directives and regulations
have improved the working conditions of employees, such as the European Working Time
Directive.
There are, however, a number of disadvantages of the European Union. Not all forms
have been able to survive the competition from firms in the different EU countries, leading
to some workers becoming unemployed. Membership involves payments to be made to
the EU, with estimates of the cost per head per year varying between about £300 and
£800, although countries can also receive rebates back from the EU. Not all of its policies
have been equally successful and one of the least successful has been the Common
Agricultural Policy where farmers have been paid to not produce anything to bring down
the oversupply of certain produce. Not all countries have joined the single currency, the
euro, which was established in 1999 as an accounting currency and as a physical
currency with notes and coins in 2002, while those countries that have joined it have found
that many major economic decisions are taken by the European Central Bank in Frankfurt
rather than by their own central banks, such as decisions on interest rates.
In June 2016, the UK held a referendum to decide whether it should remain in, or leave,
the EU. It voted to leave. This process is likely to take up to 2 years. This will then leave
the EU with 27 member countries and reduce the size of the EU from over 500 million to
about 440 million people.
In conclusion, it is clear that there are both advantages and disadvantages of a country
being a member of the European Union.
Exam-style questions
13 Student answer:
The effective exchange rate means that the value of the pound is being compared
against other currencies in terms of its value against a trade-weighted basket of
currencies. The nominal effective rate means that the exchange rate figure of 82.2
has not taken inflation into account. The real effective rate means that the
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
23
TOPIC 4
The global context
exchange rate figure of 90.1 has taken inflation into account, i.e. it is at purchasing
power parity. Both figures are being compared with the values in 2005. To enable
a comparison to be made with the earlier year, the value is given a figure of 100,
known as a base year index. Both the nominal and the real effective rate figures for
the pound show that there has been a decline in its value since 2005.
The differences between the figures shown in the table are clearly explained. MARK: 4/4
14 Student answer:
Multinational firms have had a significant impact on the world economy, both
positive and negative.
It would have been useful if a definition of a multinational firm had been included in the answer.
On the positive side, they can be a significant source of employment, reducing a
country’s unemployment rate. This will increase incomes in an economy,
contributing to a positive multiplier effect. The government will receive receipts
from taxation, both from the taxes on the profits of the company and from the taxes
paid by the employees, both direct taxes (such as income tax) and indirect taxes
(such as VAT). The workers employed by the multinational firm will learn new
skills, making them more productive and, in the long run, more occupationally
mobile.
The reference to a positive multiplier effect is useful, but the candidate does not actually explain
what this means. The candidate might also have questioned the extent to which a great deal of
employment would be created, because if the firm mainly used capital-intensive methods of
production, not many workers may have been needed.
On the negative side, however, many of the top management of the firm will come
from the original country and there may not be any opportunities in senior
positions for local people. The jobs that the factory workers have may be relatively
low-skilled, and so are sometimes called ‘screwdriver jobs’. Sometimes, a
government may have offered favourable tax concessions to attract a multinational
firm to locate in a country and so it may be the case that little of the profit is taxed.
Much of what is not taxed will be repatriated back to the original country. The
multinational firm may not be inclined to stay for a large number of years, possibly
deciding to close a factory and relocate to another country.
The response could also have considered the degree to which a multinational firm will agree to
pay wages that are equal to the country’s national minimum wage, if it has one.
There are, therefore, both positive and external impacts of a multinational firm
locating in a country.
The conclusion could have been developed more fully by referring to a few of the main
arguments on both sides, before coming to a judgement as to whether the overall impact was
likely to be positive or negative. MARK: 15/25
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
24
TOPIC 4
The global context
15 B
16 A
17 A
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
25
TOPIC 5
The financial sector
Topic 5 The financial sector
The role of the financial sector in the real
economy
1 Money performs four functions in an economy.
First, it acts as a means of exchange. This means that it is generally acceptable as a
means of payment for goods and services.
Second, it acts as a unit of account or as a measure of value. This means that it enables
different products to be compared.
Third, it acts as a store of value or wealth. This means that wealth can be stored in the
form of money.
Finally, money acts as a standard for deferred payments. This means that people are able
to borrow money and pay it back at a later date.
2 Money has a number of characteristics.
Money needs to be acceptable if it is going to be used as an effective means of buying
and selling goods and services. It also has to be portable and relatively easy and
convenient to be carried around. It needs to be relatively scarce, otherwise it could
become worthless. It needs to be easily recognised so that people will have confidence in
it. Money also needs to be relatively stable in value, although this will be influenced by the
rate of inflation in an economy.
Money needs to be able to be divided into smaller denominations if it is to be used
effectively. It also needs to be durable over time. There needs to be a stability of supply to
maintain confidence in it and each piece of money needs to be uniform so that notes or
coins of a particular denomination are all equal.
3 It is possible to distinguish between two types of money supply in terms of liquidity: narrow
money and broad money.
Narrow money refers to cash in the form of notes and coins or to financial assets that can
be turned into cash relatively easily and quickly.
Broad money refers to financial assets that are less liquid and which would take longer to
be turned into cash. It includes a variety of deposits that are held in financial institutions.
4 In the liquidity preference theory, the demand for money is made up three different
motives for money: the transactions demand for money, the precautionary demand for
money and the speculative demand for money. The first two motives are interest inelastic
and are known as active balances. The speculative motive is interest elastic and is known
as an idle balance. The three motives together create the overall demand for money. The
interest rate is determined by the demand for money and the money supply, as shown in
the diagram.
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
26
TOPIC 5
The financial sector
Figure 8
5 The loanable funds theory states that the rate of interest is determined by the demand for,
and the supply of, loanable funds in financial markets. The rate of interest is therefore a
price and is determined, just like any other price in a market, by the interaction of demand
and supply. The demand for loanable funds comes from firms wanting to invest,
households wanting to buy consumer products and a government aiming to fund a budget
deficit. The supply of loanable funds comes from savings. The diagram shows that the rate
of interest will be determined by the intersection of the demand for, and the supply of,
loanable funds, i.e. at 0r.
Figure 9
The financial sector in developing and
emerging economies
6 The Harrod–Domar model is a theory of economic growth which stresses the importance
of the generation of savings which can be used to finance investment. This will increase
the productive capacity of an economy and so promote economic development. The
theory assumes a constant capital–output ratio.
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
27
TOPIC 5
The financial sector
The model therefore shows how much capital investment would be required to bring about
a certain level of economic growth, assuming a constant capital–output ratio, and the level
of saving that would be required to finance this investment.
The model was originally used in relation to developed countries, but it has also been used
in relation to developing and emerging economies.
7 Microfinance is a broad term which refers to a number of different financial services.
Essentially it refers to a source of financial services for borrowers who lack access to
mainstream banking and financial services, such as deposits, loans, payment services,
money transfers and insurance. It is therefore seen as a way of helping poor people and
low-income households escape from poverty and is an example of financial inclusion.
It can also be used by entrepreneurs and small businesses to fund economic activities.
Microenterprises may find it difficult to access financial services through traditional
financial routes and so microfinance provides an opportunity to gain access to financial
services.
It can therefore be seen as a way of promoting economic development, employment and
economic growth, especially in developing and emerging economies.
The role of the central bank
8 A central bank can perform a number of functions in an economy. As the main bank in a
country’s financial system, it can support other financial institutions, such as by acting as a
lender of last resort to an institution in need of funds. It manages the national debt, which
is the total of all debt accumulated since the establishment of the Bank of England in 1694.
The central bank acts as banker to the government, handling its accounts, and it also
controls the country’s currency through the issuing of notes and coins. It operates
monetary policy, in particular through the setting of the interest rate on a monthly basis.
Finally, the central bank oversees the financial system as a whole through a system of
regulation.
9 The ‘independence’ of a central bank refers to the degree of operational freedom it has in
a country’s financial system. The Bank of England was granted operational independence
by the government in May 1997. In particular, it is allowed to set the interest rate. This
decision is taken each month by the Monetary Policy Committee of the Bank of England.
The government, however, retains the power to set the inflation target within which the
Bank must operate when carrying out monetary policy. The inflation target is 2% and the
governor of the Bank of England must write an open letter to the chancellor of the
exchequer if the inflation rate is more than 1% outside of this inflation target.
Financial regulation
10 The FPC is responsible for the survival and stability of the UK financial system. Its main
objective is ‘identifying, monitoring and taking action to remove or reduce systemic risks
with a view to protecting and enhancing the resilience of the UK financial system’.
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
28
TOPIC 5
The financial sector
11 The PRA is part of the Bank of England. It is responsible for the regulation and supervision
of over 1,000 financial services providers in the UK, including banks, building societies,
credit unions, friendly societies, insurers and investment firms. Its main objective is ‘to
promote the safety and soundness of financial services providers by requiring them to
behave prudently, to minimise the impact on financial stability should a provider fail, and to
ensure that financial services continue to be supplied to customers’.
12 Unlike the other two institutions, the FPC and the PRA, the FCA is entirely separate from
the Bank of England. Its main objective is to ensure that the financial markets work well,
so that consumers get a fair deal. It has three statutory objectives: to secure an
appropriate degree of protection for consumers, to protect and enhance the integrity of the
UK financial system and to promote effective competition in the interests of consumers.
Exam-style questions
13 Student answer:
The process of credit creation refers to the process of financial institutions
increasing their lending by a multiple of new deposits received. When people
deposit money in a financial institution, some of this money is kept in reserve and
the rest is lent out. This has the effect of increasing the money supply. This
multiple is known as the credit creation multiplier.
The candidate has a reasonably clear understanding of the credit creation process.
A financial institution can keep a relatively small percentage of assets in a
relatively liquid form and use the remainder to make loans. This is known as
fractional reserve banking, i.e. a financial institution will accept deposits, but only
hold a fraction of these as liquid reserves, leaving the remainder available for
withdrawal.
The candidate has quite a good understanding of fractional reserve banking, but the answer
would have been helped by the inclusion of an example of the bank credit multiplier in operation.
MARK: 3/4
14 Student answer:
The Fisher equation can be used to indicate the quantity theory of money. This
shows the relationship between the money supply and the price level in an
economy. The Fisher equation is MV = PT, where M refers to the quantity or stock
of money or money supply, V refers to the velocity of circulation of money, P
refers to the general level of prices in an economy and T refers to the number of
transactions financed by this money in a given time period.
The candidate has demonstrated a reasonably sound understanding of what is meant by the
Fisher equation.
V and T are assumed to be constant, so the theory shows that there is a direct
relationship between changes in M and changes in P. The theory plays an
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
29
TOPIC 5
The financial sector
important part in Monetarism where inflation is regarded as being largely caused
by changes in the money supply, i.e. a change in M can have a direct effect on P.
The candidate has developed the explanation to show how it can be used in Monetarist
explanations of inflation. MARK: 3/4
15 Student answer:
There are three financial regulatory bodies in the UK. These bodies became fully
operational in April 2013 when the Financial Services Act 2012 came into effect.
The candidate has provided a brief historical background to put the system of financial
regulation into context.
The Financial Policy Committee of the Bank of England (FPC) is responsible for
the survival and stability of the UK financial system. Its main aim is identifying,
monitoring and taking action to remove or reduce systemic risks. As a result of
carrying out this role, it protects and enhances the strength of the UK financial
system.
The candidate has explained the role of the FPC, especially in terms of removing or reducing
systemic risk.
The Prudential Regulation Authority (PRA), like the FPC, is also part of the Bank
of England. It is responsible for the regulation and supervision of over 1,000
financial services providers in the UK, including banks, building societies, credit
unions, friendly societies, insurers and investment firms. Its main aim is to promote
the safety and soundness of financial services providers by requiring them to
behave prudently.
The candidate has explained the role of the PRA, especially in terms of the regulation and
supervision of the variety of financial institutions that operate in the UK.
Unlike the other two institutions, the Financial Conduct Authority (FCA) is
separate from the Bank of England. Its main objective is to ensure that the financial
markets work well, so that consumers get a fair deal. It has three main aims and
these are to secure an appropriate degree of consumer protection, to protect and
enhance the integrity of the UK financial system and to promote effective
competition.
The candidate has explained the role of the FCA, especially in terms of securing consumer
protection, promoting competition and protecting the integrity of the UK financial system.
MARK: 4/4
16 B
17 D
18 C
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
30
TOPIC 5
The financial sector
19 D
OCR A-level Economics
© Terry Cook 2016
Macroeconomics 2
Hodder Education
31